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A new accounting standard that creates volatility in companies’ effective tax rates
may mislead investors who use corporate financial statements to make decisions, analysts
caution.

By tethering earnings to stock prices, the standard can cause a company’s effective
tax rate and other important financial figures to fluctuate. While many companies
today are seeing the positive effects of the accounting change in the form of tax
benefits, they may see the reverse in a bear market.

The Financial Accounting Standards Board guidance, issued in March 2016, relates to
the way share-based payments to employees are accounted for and presented in companies’
financial statements. It requires excess tax benefits and tax deficiencies to be recorded
in the income statement when stock awards vest or are exercised.

Accounting Standards Update (ASU) 2016-09 became effective for public companies this
year, with opportunities for early adoption.

A Bloomberg BNA analysis of the top 50 companies in the Fortune 500 found that beginning
as early as the first quarter of 2016, 24 out of 42 disclosed more than $1.7 billion
in total excess tax benefits for the quarter in which they adopted ASU 2016-09. The analysis excluded private companies, public companies that don’t offer stock-based
compensation, public companies that plan to adopt at a future date, and any government-sponsored
entities.

In addition, 12 early adopters that have filed an annual report since adopting the
standard disclosed more than $2.3 billion in excess tax benefits. Alphabet Inc., the
corporate home of Google, was the largest contributor, reporting $1 billion in excess
tax benefits for the fiscal year ended Dec. 31, 2016.

Companies with significant excess tax benefits saw favorable changes to their effective
tax rates as a result of adopting the standard.

The effects of the standard can vary drastically depending on the amount of stock-based
compensation companies offer and whether their stock price is falling or rising, said
Takis Makridis, president and CEO of Equity Methods LLC. The accounting change “was
heralded as a simplification initiative,”
but in reality FASB has inserted more variables “that cause financial statement numbers
to move in different directions,”
he said. This greater volatility creates “more of a tinder box for confusion and flawed
comparability” for stakeholders, he said.

Prior to ASU 2016-09, tax benefits in excess of compensation cost—sometimes called windfalls—were recorded
in equity. Tax deficiencies—shortfalls—were recorded in equity to the extent of previous
windfalls, and then to the income statement.

Five Percentage Point Tax Rate Drop

The accounting change for share-based payments led to an average decrease of almost
5 percentage points in effective tax rates across almost 200 companies that adopted
the standard early—and provided enough information to compute the figure—Derek Johnston,
an associate professor of accounting at Colorado State University, told Bloomberg
BNA.

Johnston cited preliminary findings of research he is conducting with Colorado State
assistant professors James Stekelberg and James Brushwood and professor Lisa Kutcher.
The four are studying tax-related reporting by 271 companies that applied the FASB
rules early. That number excludes utility and financial service companies and companies
that reported negative pre-tax income.

The average impact on the “GAAP effective tax rate,” or average rate at which pre-tax
income is taxed, was negative 5.76 percentage points for 192 early adopters that disclosed
information necessary to draw up a number, Johnston said. After controlling for outliers
that could distort the average, the average is about negative 4.75 percentage points,
he said. “That’s pretty significant.”

One notable early adopter, Facebook Inc., reported a seven percentage point drop in
its effective tax rate according to generally accepted accounting principles (GAAP)
after it adopted the standard last year. The company also said the new accounting
rules reduced its provision for income taxes by $934 million for the year ended Dec.
31, 2016.

The Bloomberg BNA analysis of top Fortune 500 companies found a similar trend among
both early and non-early adopters.

Bank of America Corp., which reported $222 million in excess tax benefits in the first
quarter of fiscal year 2017, saw its effective tax rate drop 4.2 percentage points
in the same quarter. It attributed the decline in part to adoption of the new standard.
Similarly, Wells Fargo & Co., which disclosed an excess tax benefit of $183 million
in the first quarter of 2017, saw its tax rate drop 4.6 percentage points from the
previous year. The bank attributed the drop primarily to the accounting change.

Of the companies Bloomberg BNA analyzed, Bank of America, Wells Fargo, and Alphabet
disclosed some of the largest excess tax benefits.

Those results make sense because the biggest stock grantors are traditionally companies
in the technology, financial services, and life sciences industries, Makridis said.

Early-Adopting ‘Delight’

Makridis said investors should be aware that these significant decreases in effective
tax rates for accounting purposes don’t actually translate to lower taxes being paid
to the Internal Revenue Service. “The actual checks written to the IRS are unchanged,”
he said. ASU 2016-09 only changes how the tax effects of stock compensation are reflected in a company’s
financial statements.

Jack Ciesielski, president of R.G. Associates Inc., an asset management and research
firm in Baltimore, took a deep dive late last year into the financial disclosures
of 343 early adopters. In an Oct. 25, 2016, edition of The Analyst’s Accounting Observer—a
research service published by R.G. Associates—Ciesielski found that the early adopters
experienced “delight” in using the new accounting rules for share-based payments.
They were able to report good news—windfalls in the form of income tax benefits and
substantial drops in effective tax rates, cutting their current-year tax provisions.

But Ciesielski dampened the party-like mood with cautionary notes for investors and
companies, explaining that a simple accounting change was responsible for these fluctuations.
“Unless it’s spelled out clearly, investors won’t understand that an improvement might
be less exciting than it seems,” he said.

Makridis agreed that unless companies are clear in their disclosures, investors could
misconstrue the tax windfalls and effective tax rate changes as something they’re
not.

Yosef Barbut, national assurance partner and a CPA with BDO USA LLP, said ASU 2016-09
brings the accounting for the tax effects of stock compensation into closer alignment
with the “cash tax” that is actually paid to the IRS. Stakeholders who are reviewing
financial statements can now base decisions off of information that is closer to actual
cash tax reality, he said. “The reality is you are getting a benefit,” he said. A
profitable company that pays tax to the IRS will get a deduction when share-based
payment awards are exercised or vest.

Transparency Concerns

ASU 2016-09 requires that companies disclose the income tax effects of adopting the new standard
in “first interim and annual period of adoption,” meaning the quarter in which they
adopted the standard and the annual report thereafter.

Outside of those disclosures, the companies only need to report the tax effects of
the accounting change if they are material.

Ciesielski wrote that as of Oct. 10, 2016, the 343 early adopters he studied hadn’t
disclosed the effects of their adoption very well. When given a choice on how to shift
to the new reporting—either by what is known as the “modified retrospective” method,
with limited look-backs in the accounting, or the prospective method—“most picked
prospective with poor disclosure of effects.”

Nine months later, his analysis of the quality of disclosures still holds, Ciesielski
told Bloomberg BNA. Companies probably won’t put much of a spotlight on the accounting
change in their income tax disclosures, which are known for being complex and ignored
by investors, he said.

In addition, Ciesielski said he doesn’t foresee that accounting watchdogs at the Securities
and Exchange Commission will pay close attention to the disclosures, “because it’s
not a recurring footnote,” he said, and therefore not suitable for timely reminders
by regulators going forward.

The SEC declined to comment.

‘Purposefully Murky’

Companies’ footnote disclosures on income taxes “are usually purposefully murky,”
said Ciesielski, who has helped advise FASB on various panels and served on the accounting
rulemaking committee of the American Institute of CPAs.

Detailed disclosures about taxes can help draw road maps for taxing authorities such
as the IRS, said Ciesielski and a Big Four firm auditor interviewed by Bloomberg BNA.
The auditor sought anonymity because he isn’t authorized to speak to reporters.

Bloomberg BNA’s analysis of the Fortune 500 found that, while companies provided varying
degrees of specificity in their financial disclosures, the majority at least noted
that they had adopted the new accounting standard and disclosed the excess tax benefits—none
reported deficiencies—or claimed that the standard had an immaterial impact. Out of
the 42 relevant companies, 31 percent said adopting the standard had an immaterial
impact in the quarter of adoption. Fifty-seven percent disclosed an excess tax benefit
amount when they adopted the standard. However, these percentages may be higher than
average.

“This group of companies should represent the honor roll, so my suspicion is that
we’d see even more heterogeneity as we exit the” top 50 Fortune 500 companies, Makridis
said.

It’s imperative that companies are as clear and transparent as possible, he stressed.
If companies don’t provide detailed reporting for investors, they risk creating more
volatility in the stock market when the stock compensation accounting change is already
volatile enough, Makridis said. All it takes is a pullback in the market to turn a
$1 billion windfall today into a much smaller windfall or a shortfall, depending on
how many stock compensation awards vest or are exercised in a reporting period, he
said.

Surprises “rattle the capital markets,”
Makridis said. Companies should give investors “this information upfront so there
aren’t these surprises down the road when someone correctly or incorrectly expected
one result and got a very different result.”

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